Introduction
For small business owners everywhere, merchant cash advances (MCAs) have been on the rise for their convenience in delivering fast and easy access to working capital. Most entrepreneurs resort to these temporary financing options to satisfy short-term cash flow requirements in hopes that everything will go smoothly. But while they are available, merchant cash advances are a dangerous choice for small businesses. In this article, we will dissect what merchant cash advances are, how they function, and why they may be more dangerous than they appear at first glance, even with their quick funding abilities.
What is a Merchant Cash Advance?
A merchant cash advance is a form of financing where a company is given a sum of capital upfront in return for a share of its future credit card sales or daily bank deposits. It is not technically a loan since the repayment is based on the business’s daily income, as opposed to a set monthly payment schedule. This format is attractive to business owners who may not be able to secure a traditional loan because of bad credit or no collateral.
The procedure for acquiring an MCA is straightforward. The business owner submits an application to a merchant cash advance provider, and if they are approved, they are given a lump sum of capital. The MCA repayment is automatically withdrawn from the daily credit card sales or bank deposits of the business. The rate of repayment is normally a flat percentage, so the amount to be repaid varies with the daily sales. This may ease the repayment by businesses because they repay more when they earn more and less when they earn less.
How Merchant Cash Advances Work
If an entrepreneur chooses a merchant cash advance, the lender advances them a lump sum amount of money upfront. It is based on the projected future business sales, usually in terms of a multiple of the business’s average daily bank or credit card receipts. The business will then repay the advance in exchange for a percentage of its daily sales.
In contrast to typical loans, under which the firm makes fixed payments every month, the repayment condition of an MCA is reliant on the revenue per day. This implies that the more the sales of the business are, the quicker the advance will get repaid. Conversely, should the business register a decrease in sales, then the amounts payable for repayment come down, which provides the firm with some easing during slow days.
The percentage of daily sales applied towards repayment is called the “holdback rate.” This may be adjustable based on the contract with the MCA provider. As an illustration, if the holdback rate is 15%, the business owner would remit 15% of their daily bank deposits or credit card sales until the advance has been paid. The repayment is normally automatic, with the provider withdrawing the amount agreed on directly from each day’s sales from the business.
Why Merchant Cash Advances are Popular
The primary reason many business owners choose merchant cash advances is the speed and ease of the funding process. Traditional loans can take weeks, sometimes even months, to process. In contrast, MCA providers can approve and fund an application in a matter of days, sometimes even within 24 hours. This makes it an attractive option for businesses that need immediate cash to address urgent expenses, such as inventory purchases, payroll, or unexpected bills.
One more attractive aspect of merchant cash advances is the fact that qualification is not so strict. Businesses usually need a good credit history, good business history, and collateral to back the loan in traditional loans. Merchant cash advances, on the other hand, hinge on the amount of daily sales volume the business is making, so businesses that may not qualify for a traditional loan are eligible for a merchant cash advance.
For entrepreneurs with low credit ratings or those who have just started their businesses, an MCA might appear to be a perfect option. It allows access to funds without going through a long approval process or losing personal assets.
The Risks of Merchant Cash Advances
Although the velocity and convenience of merchant cash advances can be very attractive, there are a few risks associated with this type of financing. The risks can negatively impact small companies, particularly companies that are cash flow or financially challenged.
- High Costs and Fees
One of the greatest disadvantages of merchant cash advances is that they are very expensive. Although the repayment terms can appear to be flexible, the total cost of the advance can be far greater than other types of financing, like traditional loans. MCA lenders tend to charge high factor rates, ranging from 1.1 to 1.5 or even higher, based on the risk level of the business.
The factor rate is a multiplier which determines the business’s total that it will pay back. A $10,000 MCA might be used, for instance, and then a factor rate of 1.3 by the provider will cause the business to pay back a total of $13,000. Thus, the business pays back a greater amount than the one which they originally took out, and the price tag on the MCA rises due to this.
Apart from factor rates, there could also be other concealed charges for the MCA, like application charges, processing charges, or prepayment penalties. These charges can add up pretty fast, increasing the total cost of the financing even further.
- Short-Term Nature of the Advance
Merchant cash advances are meant to be short-term funding options, usually for a few months or one year. This may work for companies in need of instant capital, but the brief repayment time creates stress in the business to make enough revenue to pay the repayments on a daily basis.
Because the repayment amount is linked to daily sales, a company that has a decrease in revenues might be unable to repay. If the company does not make sufficient sales to pay the daily repayment, it might be penalized or charged additional fees. This might create a cycle in which the company cannot repay the advance and has to incur another MCA to pay for its costs, thus accumulating more debt.
- Effect on Cash Flow
One of the largest issues of merchant cash advances is its effect on cash flow. With traditional loans, companies have a set amount that they must pay each month. With MCAs, however, businesses have variable payments tied to daily sales. Although this is useful during high-sale months, it can also be difficult when the company experiences lower months with fewer revenues.
Since the business owner repays a percentage of daily sales, it means that a portion of their income is automatically deducted every day. This can strain cash flow, especially for businesses in seasonal businesses or with fluctuations in revenue. In certain instances, the repayment requirements might be so steep that the business will find it hard to meet other financial commitments, including paying suppliers or meeting operating expenses.
- Risk of Debt Accumulation
Since merchant cash advances are readily available, entrepreneurs might feel inclined to borrow several advances, particularly if they encounter difficulties in servicing an existing advance. This may result in a vicious debt accumulation cycle where the business is borrowing new advances to service older ones, resulting in a snowball effect of compounding debt.
Once a business is caught in this cycle, it can be very hard to escape. The daily repayment figures keep draining the cash of the business, making it more challenging to generate sufficient revenue to service the debt. This may lead to financial hardship or even bankruptcy if the business does not discover how to deal with its debt.
- Lack of Regulation and Transparency
Another issue with merchant cash advances is the absence of regulation and transparency in the business. While government agencies heavily regulate traditional loans, MCAs are frequently exempt from the same degree of oversight. This allows MCA providers to dictate their own terms, charge excessive fees, and employ aggressive collection practices without much regulation.
The absence of standardization may confuse business owners into comparing various MCA providers without being able to fully understand the terms of agreement. In most instances, business owners might not be able to fully understand the cost of advance, the associated fees, and the repayment term until after the contract has already been signed.
- Reputation of MCA Providers
The merchant cash advance business has gained a reputation for having some shady operators who exploit small businesses in dire need of funds. Some lenders might take advantage of business owners who are not aware of the terms and conditions of the advance, presenting them with seemingly good deals that soon become expensive and onerous debt.
In extreme cases, MCA providers have been known to get involved in predatory lending, including high fees and aggressive collections. This places businesses in a vulnerable position where they are stuck with high interest rates, relentless collection calls, and increasing debt that is almost impossible to repay.
Conclusion: Balancing the Benefits and Drawbacks of Merchant Cash Advances
Merchant cash advances provide a fast and easy means for business owners to access capital, making them appealing to those in need of immediate funding. Nevertheless, the dangers inherent in MCAs should not be downplayed. The steep fees, brief repayment periods, and effects on cash flow can place considerable fiscal burden on businesses already experiencing difficulties. Further, the absence of regulation and publicity in the industry can expose owners to aggressive lenders and unjustified terms.
Before opting for a merchant cash advance, business owners should carefully evaluate their financial situation and explore alternative funding options. Traditional loans, lines of credit, or even crowdfunding may offer more favorable terms and lower costs in the long run. If an MCA is the only option available, it is crucial for business owners to thoroughly understand the terms of the agreement, including the factor rate, repayment schedule, and any additional fees involved.
In the end, while merchant cash advances might bring about fast funding access, one must be cautious using this type of financing, since the hazards linked with such funding could become greater than advantages. It is vital for company owners to decide smartly and reflect on available choices prior to going for an MCA.
